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Quality combined with expertise and insight can yield results beyond the expected

Category: Global

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We would like to think that the investment products we choose are high quality, but in the investment world, quality means more than just a good fund or high performing fund manager. At Northern Trust, we define quality as a function of various fundamental attributes that measure a company’s ability to sustain and grow its earnings and cash flow.

We have created a proprietary method of quantitatively measuring the quality of the stocks in which we invest based on three categories of business performance:

• Management: one way to test the quality of a company is to evaluate whether the management team is a good steward of shareholder capital. We believe that a quality firm has prudent investment management and uses its capital judiciously.

• Profitability: our research shows that firms with higher profitability deliver excess returns to shareholders in the form of higher earnings, cash flow and dividends.

• Cash: quality companies have more than enough cash on hand to meet their debt obligations and day-to-day liquidity needs.

Using these categories we then develop a quality score that can be used to assess the quality of the stocks in which we invest. The application of quality is not universe specific, but rather can be implemented across many benchmarks.

Northern Trust analyses have shown that quality companies outperform the market over time and do so with lower volatility. For investors, this means that a consideration of quality within a portfolio could lead to superior investment performance.

Based on – and tailored to – each investment product, additional factors enter into our core quality philosophy. Our research leads us to conclude that effective methods to implement quality may differ based on, for example, capitalisation range and portfolio objective. For example, Northern Trust strategies focused on dividend yield also include the assessment of cash factors when evaluating the strength of a company relative to its peers. While nuances exist regarding the exact proprietary metric of quality used within each product and market segment, consistency lies in using a multi-factor approach to actively seek quality companies in a risk-controlled manner.

The quality effect

Our experts have conducted research into the quality effect, looking at the implications of screening for quality. We backtested the performance of our quality score in the US (based on the Russell 3000 universe) and outside the US (based on the MSCI World ex-US universe). Stocks in each universe were divided into quintiles, with a ‘1’ indicating the highest-quality stocks and a ‘5’ reflecting the lowest quality stocks. In Table 1, the top section shows the quality score performance in the US universe, and the bottom section shows the quality score performance in the non-US universe. The returns (orange) show that the top quintile of quality had the best relative performance in both the US and non-US universes. We then took our analysis a step further, looking at how volatile the performance of these stocks was over the same period. The second column shows that the securities with the top quality score also had relatively low volatility. The combination of high returns and low volatility generated the highest information ratios in the top quality score quintiles. Furthermore, as we would expect, companies in the highest quality score quintile also had above-average dividend growth (green).





While the quality score showed strong historical excess returns and strong risk-adjusted performance, our research shows that quality alone can lead to periods of underperformance. Since price is not a major component of the quality score factor, the valuation of the stock does not determine which companies are classified as quality. At times, quality can be expensive, which can lead to periods of underperformance depending on the premium or discount the market assigns to quality companies.

We would advocate pairing quality with another factor, such as dividend yield or lower volatility. For example, when we combine stocks with the highest quality scores and highest dividend yields into a single portfolio, the excess returns increased. However, portfolios designed in this way can have characteristics that lead to undesired market exposures (low beta, value bias, sector concentration).

“The important thing to understand is that when ‘quality’ is paired with another factor, such as dividend yield or lower volatility, there is an even stronger story to tell,” said Matthew Peron, head of active equity at Northern Trust. “For example, when we combine stocks with the highest quality scores and highest dividend yields into a single portfolio, the excess returns increase. But it is also important to address undesired risk exposures. For our quality-dividend yield portfolio, for example, we developed the Quality Dividend Focus strategy, which has shown strong historical excess returns and improved information ratios that have persisted over different market cycles.”
 

For Asia-Pacific markets, this is directed to institutional investors, expert investors and professional investors only and should not be relied upon by retail investors

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